The current level of optimism among Wall Street analysts—whether measured by five-year earnings growth expectations or the proportion of buy ratings—has reached historical extremes. Historical experience suggests that such extreme sentiment often coincides with market turning points. Investors need to guard against the risk of “expectation gaps” under overly high expectations, prudently assess the margin of safety in their holdings, and avoid overlooking potential market pullback pressures amid collective optimism.
Data shows that since 1989, the historical average compound earnings growth rate for the S&P 500 has been approximately 6.5%. Today, however, analysts project that the average earnings growth rate for the index’s constituent companies over the next five years will reach 25.5%. This figure marks the highest level since records began in 1995.
This optimism may reflect the market’s belief in artificial intelligence as a transformative technology that will significantly boost corporate productivity. During the height of the internet bubble, analysts exhibited similar behavior, as the proliferation of the World Wide Web also carried numerous promises for businesses at that time.
The optimistic outlook for earnings growth has also driven the number of “buy” ratings for S&P 500 components to a record high. According to FactSet Insight data, as of the end of May this year, 59.5% of all analyst ratings for S&P 500 constituents were classified as “buy,” the highest level since records began in 2010.
During the formation and peak of the internet bubble, analysts also issued a greater number of buy ratings. However, before new regulations in 2002 required disclosure of rating distributions, analysts had little incentive to assign ratings other than “buy” to the stocks they covered. Notably, the proportion of buy ratings peaked around mid-2000, coinciding with the internet bubble’s collapse.
Similarly, ahead of the bear markets in 2018 and 2022, both buy ratings and long-term earnings growth expectations registered peaks. Currently, the market may be witnessing yet another analogous scenario.
Investment manager Tobias Carlisle has pointed out that analysts’ five-year earnings growth forecasts are almost always wrong. “This is more of a sentiment indicator than a trustworthy prediction. Analysts have a poor track record with five-year earnings forecasts, and their predictions tend to be most off the mark precisely when they are most extreme.”
Just because analysts’ optimism toward the S&P 500 has reached rare levels in recent years does not mean the stock market will not continue to rise. However, investors should not forget that stock valuations are based on future expectations. If stock prices keep climbing, companies will need not only to beat current expectations but also to ensure that expectations continue to be revised upward. This also explains why it is not uncommon for a popular stock to see its price fall after reporting earnings that beat estimates—generally speaking, the higher the expectations, the harder they are to surpass.
This is precisely why Warren Buffett’s simple investment strategy has proven effective. In his 1986 letter to shareholders, Buffett wrote: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” Given that analysts’ record-high long-term earnings growth expectations far exceed historical averages, it is fair to say that fear is scarcely visible on Wall Street.
However, this is not to assert that the market cannot push stock prices higher. After Buffett made his remarks in early 1987, the stock market rose more than 16% by the third quarter of that year, only to plummet more than 20% in a single day in October.
Although a repeat of a “Black Monday”-style crash is relatively unlikely, investors should focus on companies whose stock prices trade at significant discounts relative to expected earnings growth. This approach provides a larger margin of safety should anticipated earnings fail to materialize.
